Regulation is meant to reduce risk and protect the financial system—but when poorly coordinated or misaligned, even well-meaning rules can produce unexpected outcomes. These unintended effects are increasingly common in today’s complex and fast-evolving regulatory environment, a phenomenon now being referred to as “regulatory backdraft”.
According to Corlytics, borrowed from firefighting terminology, backdraft occurs when trapped heat and smoke suddenly ignite upon contact with oxygen. In regulatory terms, it describes when new rules intended to fix one issue unintentionally spark new problems elsewhere. This can overwhelm compliance functions, increase operational risk, or lead to gaps in oversight.
Regulatory backdraft happens not because of bad policy, but because of complexity and timing. It often stems from efforts to fix one area of risk that push issues into another. And it’s not always immediately obvious where the new pressure points will surface—until systems start straining under the weight.
Several patterns frequently contribute to backdraft. One is regulatory interpretation. When rules are enforced differently across jurisdictions, firms are left trying to implement overlapping and sometimes contradictory controls, increasing risk instead of reducing it.
Timing is another issue. Regulations can lag behind innovation. By the time new rules are finalised, the market may have already evolved, rendering the regulation misaligned with reality.
There’s also overcorrection. Following high-profile failures, there’s often pressure for regulators to act quickly. This can lead to overly restrictive rules that discourage legitimate business activity or encourage risky workarounds.
Regulatory arbitrage adds to the problem. When rules tighten in one region, firms may move activities to jurisdictions with looser oversight, shifting risk to the edges of the system. And regulatory fatigue means that rapid-fire rulemaking can overwhelm teams and systems, increasing the chance of missed issues.
The consequences of backdraft are evident in several recent cases. MiFID II, for example, was introduced to improve transparency in financial markets. But the scale of data reporting it demanded created information overload, muddying the very clarity it aimed to provide.
Anti-money laundering (AML) rules also offer a cautionary tale. Fearing non-compliance, some institutions have “de-risked” by cutting ties with whole categories of customers, including those in fragile economies. This has pushed some legitimate actors out of the formal financial system and into riskier, informal channels.
In crypto, the lack of a global regulatory approach has left a fragmented patchwork. While some countries moved fast, others have done little. This inconsistency has pushed activity offshore, away from strong oversight, weakening consumer protection in the process.
Corlytics, a RegTech company focused on helping firms navigate regulatory complexity, sees regulatory backdraft as a sign that systemic change is needed. “Our platform is designed to help with this,” the company explained. “It gives firms early visibility of regulatory change. It tracks how regulation differs across countries and sectors. And it flags where policies and controls may need updating.”
To address backdraft, both firms and regulators need to change how they engage with the regulatory process. Greater collaboration can lead to smarter, more workable rules, especially if the industry is brought into the conversation early. Tools like sandboxes and pilot programmes can expose issues before rules are rolled out at scale, while ongoing review helps rules evolve with real-world conditions.
Global coordination also matters, particularly on issues like AI, ESG, and digital assets. Shared regulatory direction allows firms to build compliance programmes that are both scalable and resilient.
Ultimately, the firms that succeed will be those who can anticipate the ripple effects of regulation—who not only understand the rules but recognise how they play out in practice. Corlytics says its mission is to help firms stay prepared, “to turn regulatory insight into action… and to keep moving forward, even as the rules keep changing”.
If the regulatory spark reignites, being ready makes all the difference.
Copyright © 2025 RegTech Analyst
Copyright © 2018 RegTech Analyst
